New Rule: Let's Ban the Term 'Small Businesses' From All Future Debates

There might not be any phrase more useful for muddying up a discussion about taxes than "small business."

Take last night's debate, where President Obama and Mitt Romney rehashed a familiar two-point argument:

(1) Obama: I would like to raise taxes on income over $250,000.

(2) Romney: But you'll hurt small businesses.

When Romney and Obama go on about "small" businesses, they're not
strictly talking about size. They're talking about the way that
companies are legally organized -- partnerships, s-corporations, and
sole proprietorships that pass through their profits to their owners, who
then treat it as ordinary income on their taxes. The concern for small businesses sounds persuasive. After all, who doesn't want to protect small, vulnerable, but growing companies run by honest Americans whose income would be hurt by higher taxes?

First, many small businesses aren't really what you would probably think of as "businesses." They're just ... people working alone. Freelancers, consultants, skilled construction workers, and such often organize themselves as a business for legal and tax purposes. About 78 percent of all companies in America don't actually employ anybody other than their owner. As Jay-Z so famously put it, "I'm not a businessman / I'm a business, man!"*

For sake of argument though, let's ignore all those solo operators. Instead we'll focus only on the roughly 4.1 million companies that are both affected by individual income tax rates and have actual employees on their payrolls. We can call these "actual small businesses."

Turns out, many of these actual small businesses aren't really what you probably think of as "small." Just 1.3 percent of actual small businesses employ 43 percent of the country's actual small business workers. These are companies with 100 people or more. Think along the lines of big Washington law and lobbying firms, which are usually organized as partnerships, and can rake in hundreds of millions of dollars a year in revenue.

You might say that these numbers are points in Romney's favor. If just a few large and rich small businesses are responsible for so much of our economy, why would we tax them more and risk their ability to hire?

There are two problems here. First, at some point, you're not really arguing that we need to protect "small" businesses. You're just protecting regular old corporate profits that happen to be taxed in a slightly different way. The second is that even if you do define them by size, "small businesses" as a broad class don't really play as important a role in job creation as many politicians -- including both Democrats and Republicans -- are fond of claiming.

Back in the 1980s, researchers suggested that firms with less than 100 employees were responsible for creating 80 percent of net new jobs each year. But over time, economists have cut some gaping holes in the methodology responsible for those findings. For instance, the original study used data from establishments, or places of business, rather than individual companies. As the non-partisan Congressional Research Service noted in a report** casting doubt on the connection between individual income tax rates and hiring, that meant jobs from a Walmart location could have been attributed to small businesses.

More recent research using improved data has suggested that, when it comes to which businesses create jobs, size doesn't really matter. What's important is growth. As a 2010 study by the Kauffman Foundation showed, a relatively slim number of quickly expanding companies drive much of the new job growth in this country. These so-called "gazelles" are often start-ups, which tend to begin small before expanding. But they also often include companies with more than 10,000 employees. Below is a breakdown of the top 1 percent of growing firms, which contribute roughly 40 percent of new jobs in a year.

So size doesn't really matter when it comes to which companies create jobs. What does? The ability to attract investors, for one. And, as Kauffman foundation director of research Dane Stangler noted to me, investors generally don't like putting their money into the kinds of businesses where profits are taxed as personal income. Instead, they prefer what are called C Corporations -- which are what General Motors, Apple, and pretty much every other giant company you've heard of with shareholders and a board of directors are.

In short, the kinds of companies that Romney's worrying about when he says we shouldn't raise income taxes aren't likely going to generate many jobs to begin with. Yes, they are capable of scaling up and adding lots of workers, like in the case of large law firms, but they're probably not going to be the backbone of new employment.

Americans love to romanticize the notion of small business. That's why it makes good presidential debate fodder. But as an economic concept, it's fairly useless. It's certainly not something we should be pinning our whole tax policy on.

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*Yes, I realize I am slightly misappropriating the line. But I couldn't help it.

**An earlier version of this article incorrectly attributed the report to Congress' Joint Committee on Taxation.

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